PRICING DIGITAL PRODUCTS AND SERVICES IN
Department of Computer and Information Systems
Loyola Marymount University
Los Angeles, California 90045
Andrew B. Whinston
Department of Management Science and Information Systems
The University of Texas at Austin
Austin, Texas 78712-1175
Electronic commerce has made its entry into the main stream of market economy.
According to the U. S. Census Bureau, just the 2005 3rd quarterly ecommerce retail sales
alone was estimated at 22.3 billion dollars, which is about 2.4% of the total retail sales.
Given its increasing impact on the economy, e-commerce has attracted attentions of
scholars from a broad range of disciplines. One of the questions that still remain is: “How
to determine prices for digital products and services?” After our research on this subject,
we conclude that there is “no one size fit all” answer to this question. In most cases,
existing economic theories and pricing mechanisms can be modified to suit the
requirement of online business; however, when some products that used to be sold in the
regular market with a price tag, and now they are distributed free over the Internet, then,
pricing these products becomes a challenging issue. We have proposed a “singing lottery
ticket” pricing mechanism that might give the users the incentive to pay a small
subscription fee to download the music.
Keyword: Pricing, Electronic Commerce, Lottery
Electronic commerce has made its entry into the main stream of market economy. In the
80’s, most companies used Internet as billboard to post general information about
themselves, such as office hours, company history, and sales contacts. Start from the early
90’s, companies begins to market their products online. With the development of
“shopping cart” software and improvement on the security of online transaction,
customers have able to order goods online. Now the electronic commerce has developed
into a period far beyond selling products online. It has changes how products are
designed, manufactured, distributed and sold.
Dell Computer took the lead in exploring the online market place of mass customization
in electronic commerce. It set up online systems that let individuals design their own PC,
place orders and pay for the products all on Dell’s e-commerce web site. Once the order is
received, Dell will custom-build the PC according to customer’s specification and
delivers it on the promised date.
Inspired by Dell Computer’s success, one of the well-known build-to-stock operations
GM is planning to change into a build-to-order manufacture. However, cars aren’t
anything like computers when it comes to manufacturing. When a customer orders a
personal computer online, Dell can pull a limited number of variation using about 30
components of the shelf, snap them together and ship the computer via two-way ground
delivery. Cars, however, have 3000 or more parts; sometimes from hundreds of miles
away, and there are too many possible combinations to anticipate. Painting is not an issue
on PCs, but in reality, it consumes a huge amount of time and many parts have to be
color-coordinated. For a long time, mass production with limited choices is the way for
higher efficiency and low cost. It seems that in the information age, consumers who are
demanding more personalized products and services are the dominate force in
determining how the products are designed, priced and distributed.
From these two examples we can see that, in the age of e-commerce, products traded in
the markets will vary greatly in functionality and features. This new way of conducting
business creates pricing challenges for scientists. Personalized combinations make it
harder for determining the market price by the conventional economic methods. We need
to design new pricing mechanisms for these personalized products.
Personalized products certainly not only limited to PCs and cars, millions of iTones users
have purchased individual songs and compost their own favorite albums; thousands of
online gamers have created their cyber characters, furniture, and then, sold them through
online auctions. Given its wide impact on the world economy, e-commerce has attracted
attentions of scholars from a broad range of disciplines. At a NSF workshop hosted by the
Center for Research in Electronic Commerce at University of Texas at Austin, a group of
top-notch scientists from many different countries has identified an array of the most
crucial research topics of the new economy. One of the topics is how to determine the
market price for digital products and services that sold through electronic commerce. In a
recently published book, scholars  also acknowledge that it is still an open question:
how to determine prices for digital products and services. This important topic is what this
research is intended to address.
This paper is organized as follows: Section 2 defines what are digital products and
services, and then gives a summary of some of their characteristics that are most relevant
to this research. In section 3, we explain the significance of this pricing issue. In section 4,
we review some of the economic pricing literature and pricing mechanisms. In section 5,
we will discuss some of the pricing mechanisms that might suitable in selling digital
products and services. Section 6 concludes this paper with discussion on the implications
of this research and future works that might further our understanding in this area.
2. DIGITAL PRODUCTS AND SERVICES
The number of world Internet usage has grown 182% over the past five years (see Figure
Population Population Internet Usage,Usage Growth
(2006 Est.) % of World Latest Data 2000-2005
Africa 915,210,928 14.1 % 22,737,500 403.7 %
Asia 3,667,774,066 56.4 % 364,270,713 218.7 %
Europe 807,289,020 12.4 % 290,121,957 176.1 %
Middle East 190,084,161 2.9 % 18,203,500 454.2 %
North America 331,473,276 5.1 % 225,801,428 108.9 %
553,908,632 8.5 % 9,033,597 337.4 %
Oceania / Australia 33,956,977 0.5 % 17,690,762 132.2 %
WORLD TOTAL 6,499,697,060 100.0 % 1,018,057,389 182.0 %
Digital products and services beamed through the Internet have penetrated many aspects
of our daily lives, sometimes without we even realized their existence. Many airlines are
quietly issuing invisible e-tickets instead of the traditional paper tickets. News, weather
reports, TV programs, movies reviews come to viewers from the web rather through
traditional media such as radio or newspapers. Online banking trading and billing services
have saved customers many trips to banks. Music singles, movie clips, satellite photos,
even books are available online for everyone to enjoy. So what are digital products and
services? How can anyone identify them? In what ways are they different then the
physical products? These are the questions we will address in this section.
What are digital products and services?
In a broad sense, any product that is in a digital format can be considered as digital
product. We can categorize them in the following way:
The first group contains the products that are in digital format, but stored in a physical
material and transported as physical product. Users can make copies of these products or
up load the content into their computers and computer networks. This type of digital
products includes credit cards, music CDs, DVDs and all sorts of software on compact
The second group contains the products that are in digital format and transported to the
end user through communication cables or wireless devices. Users can print these
products on paper or download on a computer disk if they prefer. This type of digital
products includes electronic journal and books, music in MP3 format beamed through the
Internet, street maps from web site like MapQuest.com, even detailed area maps and
satellite photo through Google Earth.
The third group includes services that are represented in digital format and offered
through online or wireless connections. These types of services used to be provided
through telephone or paper based products. They now are widely available online. This
type of services includes travel reservation services, stock trading, banking services and
In this paper, we focus our attention mainly on these digital products and services that are
transmitted through the Internet or wireless connections. These digital products and
services share many commonality besides they are all transmitted the Internet. Next
section is devoted to these common characteristics.
Characteristics of Digital Products and Services
The purpose of discussing the characteristics of digital products and services is not only
for identifying them, but also for understanding the implications these characters may
have on their prices and prices setting mechanisms.
A. No loss in quality during duplication
Technology has made the duplication process of digital products simple and low cost. A
unique fact about duplication of digital products is that there is no loss in quality during
the duplication process. It is common knowledge that a paper copy made from the original
is always has lesser quality. For the audio and video magnetic tape products, it is well
known facts that the sound and image quality loss a bit after each copying. Nevertheless,
for the digital products there is no loss in quality for the original after duplication and the
quality of the copy is the same as the original one. For example, when taxpayers
download income tax forms (in digital format) from IRS web site to their computers, there
will be not reduction in quality for either the original or the downloaded copies. Because
the forms that the taxpayers downloaded are merely digital copies of the original forms
that reside in the IRS computer.
The users accept the fact of low cost and no loss in quality with great enthusiastic;
however, it created challenge for the economists. The price of physical products usually
correlated with the cost of making or reproducing the products. For digital products, the
reproduction cost is so low that it is no longer sensible to base prices on it. Economists
have to find some alternatives ways to set prices. More detailed analysis about this point
is offered in marginal cost pricing section.
B. Takes negligible storage space
Technology innovations have made unprecedented advances in reducing storage spaces
for digital data. The entire content of Encyclopedia Britannica was bounded in 32
volumes set and priced at over $3000 a set. Now it can be stored in few compact disks and
only cost $49 to own (http://www.britannica.com). One of the latest advances in digital
revolution is a remarkable Apple Computer’s iPod (http://www.apple.com/ipod/ipod.html).
Its size and its appearance are somewhat deceptive, for the iPod can hold more than
15,000 typical songs in the popular MP3 format that is large enough to hold a lifetime’s
collections of favorite tunes. These two examples are only the few among the vast
varieties of storage devices. According to computer scientists, what has been more
dramatic in the last decade is the doubling of magnetic densities every 12 months and
doubling of optical network bandwidth every 8 months. With such speed of development,
we might have infinity of memory capacity and infinity of bandwidth in short time.
What are the implications of this to digital products and services? So far, the prices of
computer memory have been steadily falling; prices for digital products have been
following this trend. With dramatically increased bandwidth, there might be more
graphical and interactive digital services available through the Internet or wireless
C. Timely delivery
Almost all the digital services are available on the web 24 hours a day. Digital products
can be downloaded to consumer’s PC just in time they are ordered. Many educational
entities have used this character to provide low cost, convenient training programs to their
trainees. For example, online traffic schools offer trainees all the necessary training
materials and a completion report to the corresponding agencies 24 hours a day. The cost
of the online traffic school is only a fraction of that the traditional classroom version
training program. For the consumers it is hard to pass on such convenience and low prices
services that were not common in brick-and –mortar stores. For the services providers the
Internet is another way to cut their business cost and expand their marketing channels.
Web sites that provide both convenience and low price services to consumers are
sprouting on the Internet. For instance, www.imbd.com provide movie and TV database
to viewers, it contains information about 200,000 movies and TV shows, 400,000
actors/actresses, ratings, local showing schedules. All these services are offered at one
unbeatable price --- free. These kinds of online services made pricing digital services
difficult. The notion of free is contradictory to traditional business mentality, which
believes any business, in order to last for some time, should charge consumers for its
services or collect money from other sources, at least to cover its cost. However, there are
so many services like imbd.com, which doesn’t charge consumers, and has no
advertisement either. Their number is large enough that set a “free for all” trend on the
Internet. For the online services that are thinking about charging for their services, the
questions are: “Are the consumers going to pay for the services?”
D. Ease of transferring and processing
Another characteristic of digital products and services is that they can be transferred and
processed more accurately, efficiently and at lower cost that manual process. It is not
surprise that Internal Revenue Services (IRS) have implement programs to replace some
of its tedious manual processes. For example, IRS e-file enables taxpayers to file a tax
return electronically to the IRS. Once the electronic returns are received by IRS could
check for errors and irregularities in the returns immediately. In summary, e-file has the
following advantages to the taxpayers comparing to paper filing: The chance of getting an
error noticed by the IRS is significantly reduced, because IRS e-file is more accurate (less
than 1% error rate) than mailing a paper return. Taxpayers get proof that the IRS has
accepted their return within 48 hours. As result, taxpayers get their refund in half the time
it usually takes. Such convenience and accuracy in transferring and processing could save
organizations in data entry cost, which in turn may lead to lower price for the same
In this section, we have discussed four major characteristics of digital products and
services and pointed out some the implications to pricing. On one hand, these special
characteristics mentioned above provide opportunities for new products and services; on
the other hand, they raised many questions for scholars and businesses are like. In the next
section, we will turn our attention to the significance of pricing digital products and
3. THE SIGNIFICANCE OF PRICING DIGITAL PRODUCTS AND SERVICES
Finding the right pricing mechanism for digital products and services is an important
issue. It has major implications in the development of e-commerce. There is more people
log on to the Internet than ever before, and new business models and practices are coming
to the market everyday. Some of the traditional pricing schemes that have been trusted for
decades are no longer suited to requirement of the online business. Therefore, we have to
address the pricing issue in light of changes and challenges of cyber space.
Like automobile and airplanes that revolutionized the way people travel, the Internet has
revolutionized our way of communication. Combining multimedia features telephone and
television, it capable of transmitting enormous digital information, let it be sound, text,
images, motion pictures, to every corner of the world, to anyone who are equipped to
receive the information. Unlike radio and television that only broadcast information to the
audience, the Internet facilitates a two-way communication, on which anyone can send
and receive information at any time. For instances, Land’s End, a subsidiary of Sears, web
site has a special service called My Virtual Model that allows customers entering their
own measurements, choice of style, and look the model wearing the cloth that they just
designed. If the customer satisfied with the fit and design, they can submit a request, then
Land’s End would tailor makes clothing to customer’s specifications.
The significance of this type of mass-customization not only it indicated a growing trend
of new business practices that would be impossible to conduct without Internet and e-
commerce; it also posted new challenges on online pricing mechanism for such business
practice. With the aid of Internet, everyone could be a designer and market their products
to customers. Currently, products have a range from clothing from Land’s End, jeans at
Lewis, shoes from Nikes, online characters in the electronic games such as Sims and Star
Craft, in the future, mass-customized products could be involved into more complicated
products, such as cars or architecture drawings. There are real and practical demand in
mass-customization market to efficiently price digital products and services.
In addition to rapid growth and new business practices, another significant change is how
content-based digital products are sold. The famous Napster case is a good example to
illustrate this point. Napster facilitate online digital music exchanges by providing a
central database which content bands’ names, titles of the songs, where the music is
located on the Internet and what type of transmission line is used. Users of Napster can
select any title and download it to their own computers. Once the songs are in their PCs,
users can easily copy all the songs on to CDs or MP3 music players. Napster charges its
users no fee for the services. Recently, CD sales have declined the first time in history.
The Recording Industry Association of America and other major players in the music
industry have tried to stop such services. Even though, in 2001, RIAA made Napster
change to fee base services after series of legal battles, but other free music exchange
services sprouting out and took Napster’s place on the web, continuing the business of
providing free music singles to online users. Napster case has demonstrated that pricing
digital products is not only an economic issue, it could be a highly controversial issue that
challenge the current assumption on the ownership of copy righted products: music,
movies and books.
4. DIMENSIONS OF PRICING MECHANISMS
With fast developing in e-commerce, pricing digital products and services become an
inevitable task that faces economists, industries leaders and entrepreneurs. In this paper,
we will first analyze the pricing issue through literature review, and then present our
suggestions on what are the possible price mechanism might be adopted
Existing economic literature provides rich and valuable resources that could assist us in
search for possible solutions for pricing digital products in e-commerce. In this section,
we will first review each major pricing mechanism, and then we will discuss how these
pricing mechanisms can be applied in the e-commerce setting.
Marginal Cost Pricing
Cost is the center subject of many business decisions. Businesses must pay careful
attention to cost, for every dollar in cost reduces the firms profit. Not only so, costs are
crucial for a deeper reason: firms make future production and sales decisions based on the
costs and prices of the products. Cost is identified as one of the major factors in
determining price in traditional economic literature (Samuelson and Nordhaus 2001). This
fact holds true not only in economic theories, but there are also empirical evidence
supports the view that main influence leading to price changes is a change in the level of
cost (Nishimura 1989).
Marginal cost is one of the most important concepts in all economics. It denotes the extra
or additional cost of producing one extra unit of out put. Say a firm is producing 1000
hard disks for a total of $10,000. If the total cost of producing 1001 disks is $10,015, then
the marginal cost of production is $15 for the 1001st disk.
Most discussion of marginal cost pricing take for their basis on the work of Harold
Hotelling (1939). His presentation consists of both a mathematical treatment of the
problem and a detailed explanation of the implications of the principle. By then people
were more concerned with analysis of such public works as roads and bridges. The
services of an already existing road or bridge have no real cost, so that any diminution in
its use would represent a net loss of benefits. The greatest benefit would be obtained from
a bridge if its services were free, and the higher the roll that was charged the greater
would be the damage done.
Hotelling postulated an economy in which products are priced at marginal cost, and the
difference between this amount and the total cost is made up by taxation. In order to
illurstrated the application of marginal cost pricing, Hotelling considered two cases, one
relating to toll on he bridges and the other to railway rates. With respects to bridges, for
the use of which marginal cost is zero, in addition, Hotelling pointed out that the bridges
would be used more if there are no tolls and the cost is paid by taxes on the site value of
the land and on incomes and inheritances. If the bridge services are not sold at marginal
cost, i.e. if tolls are charged, the total amount of benefit will be decreased by the
The railroad case is similar. The running costs of railroad are only a small fraction of their
total costs, and the actual extra costs of marginal use are even smaller. In a rational
economic system, Hotelling indicated that rates should be set in such a fashion that they
would even out the traffic over the year, ensuring full utilization of capacity at all times.
Marginal cost pricing principle does not necessarily imply the use of the same rate for
both peak and off-peak periods. Hotelling’s system adequately allowed for charging
additional fees whenever the demand at marginal cost would exceed the available supply
In summary: Marginal cost pricing was originally designed to solve services charge
problem associate with public works that has large fixed cost or sunk cost, and very small
marginal cost. That is the cost of enabling the first person cross the bridge is very high,
however, the cost of enabling additional persons crossing that bridge is very small. In
order for marginal cost pricing system to work in the realistic sense, i.e. to cover the total
cost of building that bridge, it is certainly not sufficient to solely rely on collecting fees
that equal to marginal cost, there must be a specific tax or other type of fund collected. An
alternative method to cover the cost is to charge additional fees whenever the demand at
marginal cost would exceed the available supply. This leads to peak load pricing that we
will review later.
We have summarized some of the literature on the issue of marginal cost pricing. In the
remaining of this section, we will examine how close the prices relate to costs, and then
about how significant marginal cost pricing in e-commerce. Mainly, we will discuss “Is
cost always a main factor in determine price?” “How useful the concept of marginal cost
in determines digital products prices?”
Is cost always a main factor in determine price?
The answer is: “depends.” It is better to use a real world pricing practices to illustrate this
point. There is a simple rule of restaurant finance called 300% solution. (Goings) Many
independently owned restaurant owners aim for an overall 300% --- or four times--- the
cost of the raw ingredients. But some ingredients, especially prime cuts of beef and
gourmet seafood such as day-boat scallops that cost the restaurant so much that the diners
wouldn’t tolerate such a high mark up in them. Therefore, since the restaurant can’t
ratchet up the prices enough on those items, they have to make it up on the low cost
ingredients, such as salmon, lettuce and pasta. Staying outside a certain price range can be
risky for a restaurant. A $3 soup on a menu where most appetizer are in the $8 to $12
range will either cause a run on the soup, or scare people away because they think
something is wrong with it. Likewise, a dish might not find takers if it is priced too high.
Indeed, there is a science to restaurant pricing. Some restaurants have computer programs
that allow them to enter content of every dish and get an exact price on each ingredient
and the overall cost of a single serving. Some people believe that it is not fare to focus on
the cost of restaurant meal’s raw ingredients, because no one would calculate the value of
a Picasso based on the cost of the paint.
How useful is the concept of marginal cost in determining the prices for digital products?
Marginal cost is the additional cost incurred in duplicating of the original product. It may
cost millions to make the original copy of a motion picture, yet the cost of make an
additional copy on a VHS magnetic tape is only a few dollars. If it is distributed through
the Internet, the cost of making an additional copy is even less. Since the marginal cost in
producing the additional copy is so insignificant compare with the fixed cost, if the price
were set as equal to marginal price, the total income from such pricing mechanism may
not cover the fixed cost. Besides, it is impractical to charge customer few cents for a copy
itself. Therefore the concept of marginal cost doesn’t provide much clue in determine
prices for digital products and services.
Peak Load Pricing
It happened many times that the demand for certain digital products or services is much
higher than its capacity. When the demand is exceed the available resource, economist
might suggest that to adopt one of two primary approaches: quality limits and peak load
pricing. The first choice requires having a central to allocate and reinforce quality limits
on consumers. The pricing approach odes not impose limits directly on the consumer,
instead it set up in such way that consumers will self-select quality and associated price
that suits them. Peak load pricing is one of the pricing mechanisms that allow consumers
make self-selection, at the same time it will allocate resource in a more efficient way. US
Postal services have long been dealing with the problem of limited resource during certain
time of the day in their mail processing operation. Mail services involve considerable
more than the transportation involved in collection and delivery. A major part of mail
services is the sorting and other operations required so that mail can get to its destination.
These sorting operations act as the primary driver of the peal load problem. Mail arrivals
in peaks, typically “originating” mail from mailers at the end of the afternoon (requiring
outgoing sorting) and “destinating” mail from other mail centers arrives in the early
morning (requiring incoming sorting). Because this must be sorted within a limited
number of hours to make delivery deadlines, a peak load problem arises. Postal services
currently address this problem by using services differentiation that is dividing mail into
classes with different priority in delivery. Crew and other researchers has studied this
problem and demonstrated that such services differentiation, through deferred processing
of lower priority mail at the peak times, but it did not eliminate the peak load problem.
Similar situations happen in the digital communication services over the Internet. One of
the well-known incidents happened when AOL first changed from usage-based pricing to
flat rate connection fee, suddenly there were overwhelming demands for its Internet
services. Since then several Internet digital services pricing proposals have been presented
in the literature. One of the most comprehensive researches on this topic is done by .
They proposed that to easy the peak load problem is to provide multiple services classes
characterized by different performance levels. In the multiple level services networks,
jobs in the higher class are transmitted before the jobs in the lower class. Base services
can be thought of as a lowest best effort class with users paying just a fixed access fee and
no usage-based fee. However, for the higher level of services, the user would pay
according to a usage-based pricing scheme. By means of computer simulation, they have
also demonstrated that proposed “optimal” pricing scheme might substantially increase
customer benefit while compared that with usage-based pricing and flat rate pricing.
Subscription Based Pricing
The marginal cost pf producing an additional copy of digital product is very small,
therefore, it is economically sensible for the seller to mass-produce and reach broader
market. Subscription pricing seems well suited for such strategy. Like the common
subscription, such as cellular phone services, cable TV, newspapers, magazines or books,
where subscribers pay a monthly fee and products will be delivered to the consumer on
the predetermined schedule. Many digital products and services are also sold on
subscription. For example, at PlayNow.com a $9.95 a-month subscription services offers
over 100 software programs that subscribers can play online as long as he/she wants.
Currently, the limitation is the speed of connection. A high speed Internet connection is
necessary for game-on-demand applications. It is estimated that broadband services will
reach 16.6 million homes by 2004 . By then we should see more of subscription
pricing mechanism used in digital services.
Subscription based pricing has the advantage of low according and administrative cost,
and usually consumer would prefer the simplicity of subscription than usage-based
pricing. However, the management decision is crucial, if the subscription price is too low,
it may generate excess demand over supply, which creates congestions over the network.
There may also lead what economists called “the Tragedy of the Commons”. Therefore,
subscription pricing has to be implemented with caution to avoid some of the potential
problem associate with it.
Auction is a well-studied pricing scheme. In traditional auction, there are two most
common auction formats:
Ascending Bid Auction (English Auction) in Regular Auction
An English auction customarily begins with the auctioneer soliciting a first bid for the
item from the crowd of would be buyers or announcing the seller’s reservation price (the
lowest price the seller is willing to sale the item for). Any bid, once recognized by the
auctioneers, becomes the standing bid, which cannot be withdrawn. Any new bid is
admissible if and only if it is higher than the standing bid. The auction ends when the
auctioneer is unable to call forth a new higher bid, and the item is “knocked down” to the
last bidder at a price equal to that amount bid.
Dutch Auction Format in Regular Auction
The price begins at some level thought to be somewhat higher than any buyer is willing to
pay, and the auctioneer decrease the price in the decrements until the first buyer accepts
by shouting “ Mine!” The item is then awarded to that buyer at the price accepted.
Because of the physical and geographical limitation, the regular auction only can serve a
small number of customers at a certain time.
Mass-customization was a dream for economists before e-commence takes hold in the
economy. The Internet provides two-way communication between manufactures and
consumers, multi-media user interface allows consumers to specify their preference more
precisely, and with ever growing online customer base, gradually, this dream is becoming
reality. However, the design and implementation of mass-customization web services is
just begin, and there still many unanswered questions remain. How to pricing the
individually designed product is one of them. Differential pricing is pricing mechanism
that deals with this type of products.
Economists generally follow the taxonomy of Pigou, who used the term price
discrimination to describe what we have been referring to as differential pricing. Pigou
described three different forms of price differentiation.
First-degree price differentiation means that the producer sells different units of output
for different prices and these prices may differ from person to person. This is sometimes
knows as the case of perfect prices discrimination. Under first-degree price
differentiation, each unit of goods is sold to the individual who values it most highly, at
the maximum price that this individual is willing to pay for it. If the producer has
sufficient information to determine the maximum willingness to pay of each consumer, it
will be able to extract the entire consumer surplus from the market.
Since the producer gets the entire surplus in the market, it wants to make sure that the
surplus is as large as possible. Put another way, the producer’s goal is to maximize its
profit (producer’s surplus) subject to the constraint that the consumers are just willing to
purchase the amount of the goods or services it provides. First-degree price differentiation
is an idealized concept. In order to engage in this type of pricing, the producer must know
the willingness-to-pay of its consumers and be able to prevent resale between consumers.
Before e-commerce, both of these requirements are difficult to realize in the practice and
first-degree price differentiation is not commonly observed in the real world.
Second-degree price differentiation means that the producer sells different units of output
for different prices, but every individual who buys the same amount of the goods pays the
same prices. Thus prices depend on the amount of the good purchased, but not on who
does the purchasing. The price per unit of output is not constant but depends on how
much one purchase. This form of price differentiation is commonly used by public
utilities; for example, the price per unit of electricity often depends on how much is
bought and the prices of long-distance telephone services are lowest for the largest
buyers. In other industries, bulk discounts for large purchase are frequently available.
In the third-degree prices differentiation, the producer is able to identify different
consumer groups who have different willingness to pay. This is a very common form of
pricing strategy: senior citizen discounts, student discounts, etc. are widely used.
Nevertheless, it is often difficult to tell whether a particular person belongs o which
consumer group. One way to get around this problem is to offer two different price-
quantity packages in the market. One package will be targeted toward the high-demand
person, the other package toward the low demand person. It can often happen that the
producer can construct price-quantity packages that will induce the consumers to choose
the package meant for them. In the economics jargon, the producer constructs prices-
quantity packages that give the consumers an incentive to self-select.
In practice, the producer often encourages this self-selection not by adjusting the quantity
of the goods, but rather by adjusting the quality of the goods. U.S. airlines normally offer
two kinds of airline tickets. One has no restrictions which business travelers find these
fares attractive since their travel plan may change suddenly. The other fare involved
several restrictions, such as the travelers must stay over a Saturday night, must buy the
ticket 14 days in advance and so on. The presence of these restrictions makes the ticket
less attractive to business travelers, but the restrictions are still acceptable to tourists. By
the large, each type of travelers selects the fare class intended for him or her and the
airlines make substantially more surplus than if it had to sell each ticket at one flat rate.
McAfee (1996) indicated that price/quality discrimination of the sort described could
easily make all parties to the transaction better off than if the price differentiation were
not possible. In the case of the airline tickets example, the Saturday night stay over is a
small inconvenience for tourists, but a large inconvenience for the business travelers.
There sort of restrictions are of little direct impact to the airlines, for their only purpose is
to separate the low willingness-to-pay consumers from the high willingness-to-pay
In general, economists (Schmalensee 1982; Schwartz 1990; Varian 1985) agree that price
differentiation is more efficient than no price differentiation at all, since without such
price differentiation the markets with low demand may not get served, at meantime, the
producers would find it is profitable to serve both markets. Small, niche markets will
generally not be well served if the producer is required to charge a uniform price, and
price differentiation can provide very significant efficiency gains since it allows markets
to be served.
5. MECHANISMS FOR PRICING DIGITAL PRODUCTS AND SERVICES
We have summarized the characteristics of digital products and services, and reviewed
some of the literatures and online practices of price setting strategies. One of the
Internet’s greatest advantage is it allows the online business to reach everyone on the web,
which could mean hundreds of millions of people. In addition, it enables web users to
specify their preferences in detail. Thus, demand-collection and mass-customization are
some of the popular ways for online business to sell digital products and services. In this
section, we are going to suggest few pricing strategies for online business.
Since most online services providers rely on advertisement as source of revenue. To
attract more visitors to the site is of vital importance to the business. Various techniques
have been used to attract more visitors, for example lowering price, giving free samples,
offering grocery coupons or a chance to win vacations. We will discuss how lottery might
work for some of the online products, and how mass-customization and demand
collection can be implemented on the web
Singing Lottery Tickets
The popularity of state lotteries in America has grown over the last several decades. In
1986, revenues from all games offered total 12.5 billion dollars to the states, whereas in
1996, revenues from all lottery games toped 34 billion dollars.
Besides making money for the states, lottery also was used for some other purpose. For
example, in the U.S., lottery has been proposed as an alternative method for allocating
communication spectrum (Schmalensee 1987). Demands on the communication spectrum
have increased sharply because of the growth in radio communication services, the large
bandwidth now required for transmitting images and motion pictures, and the rapid
increases in world population. The electromagnetic spectrum is a finite natural resource of
great value, which is used for emergency communications, military operations as well as
In 1980s, the US government allocated cellular communication licenses by lottery
(McMillan1995; McAfee 1996). The lotteries succeeded in assigning licenses quickly, but
the prospect of the windfall gain attracted 400,000 applicants. Assigning licenses at
random is hardly likely to put resources into the hand of the firm that are able to make the
best used of them. Therefore, in 1993, Congress decided to switch to auctions for the new
mobile communication licenses. In e-commerce, online services providers may use lottery
as a price setting strategy, which might be attractive to some of the online users.
Study has shown that lottery tickets, in the value of about a dollar each, have positive
effects on raising medical survey response rate in Australia (Kalantar and Talley, 1999;
Ward, Boyle, Long & Ovadia 1996). Medical survey is especially hard for obtaining good
response rate, since it often contains very personal and sometimes intruding questions. A
team of researchers administrated a medical survey to 400 pre-selected populations. Half
of the people received lottery tickets along with their questionnaires, and the other half of
the population received identical questionnaires but without lottery tickets. Result shown
that the group revived lottery tickets had 70% of the response rate, while the other group
has the usual 38%. May be in e-commerce, online business can increase the number of
visitation by giving out lottery tickets when the customer makes purchase orders.
Court hearing on Napster has attracted much of the media’s attention (Hunter 2002;
Michael 2001). Napster is a program that allows computer users to swap music files with
one another directly. With it, 25 millions users have logged on to Napster, to download
music files or to play songs. This application unleashes the potential of the web, the vital
growth possibilities of the community, the power of the Internet that made a leap over
barriers and transformed people’s assumptions about business, content and culture.
Napster has forced record companies to rethink their business models and record-
company lawyers and recording artists to defend their intellectual property. On behalf of
five media companies, the Recording Industry Association of America (RIAA) has sued
Napster, claiming the web site and the program are facilitating the theft of intellectual
On September of 2001, Napster has agreed to pay $26 million to settle its ongoing legal
disputes with music publishers and songwriters and suspended its music swapping
business. However, there are new, even more intractable sharing systems – notably
Guntella and Freenet – that allows file to be traded directly from PC to PC, without going
through a single website like Napster, which would be harder to shut down, because there
is now central location and no company to sue.
The music industry, having learned from the experience of Napster, is struggling to
reinvent itself for the new era. On one hand, it formed a consortium with consumer
electronic companies, to develop new standard for the digital music and devices that plays
it. On the other hand, it is trying to develop new pricing schemes that would make file
sharing seems unnecessary. But how that music will be delivered and how it will be paid
for is still very much in flux, especially if it is delivered online.
To use lottery as part of the price-setting scheme seems to be a feasible approach. A
music site can charge a small subscription fee for its users and each time the user
download a song, he/she would be given a lottery ticket with certain probability to win a
large prize. Therefore, the user would not only get a piece of music, but also a lottery
ticket. Such combination could be called “singing lottery ticket”.
There are potential drawbacks for distributing lottery tickets over the Internet, which
related to social and psychological well being of the public health. Lottery is a form of
gambling, and there are some major public health issues such as gambling addiction,
family dysfunction and gambling by youth need to be addressed. Study has linked new
technologies to gambling related problems such as addiction to gambling by video lottery
terminals (Korn 1999; Ladouceur, Vitaro and Côté, 2001) It is certain that some of these
emerging issues need to be further studied to balance risks and benefit of online services
Auction Pricing in e-Commerce
The key to a successful auction is to have sufficient number of interesting products and
sufficient numbers of buyer that will bid the price high enough, so the sellers can make a
good profit. The Internet is a perfect media to provide basic conditions for a successful
auction. By eliminating physical distance the sellers and the buyers can participate in the
same auction even they are thousands of miles apart. Online auctions offered unique
opportunities for individuals to trade with one another, which is impossible to achieve in
the brick-and-mortar market. Online auctions, such as eBay, Ubid and Yahoo Auction,
facilitate individual-to-individual trading in an auction format on the web. The items that
are for sell are usually antiques, arts, books, movies, music CDs, computers and real
estates. The average sales price is about $30. Currently there are over 7 millions of users
participating in the online auctions and everyday there are thousands of online auctions
Ascending Bid Auction (Reserve Price Auction) in Online Auction
When a seller uses the reserve price option, they set a reserve price, which is the lowest
price at which a seller is obligated to sell an item. The seller specifies the reserve price
when he or she lists an item, which is an amount over the minimum bid. Then when the
auction begins, it will start at the minimum bid amount that the seller also chooses.
During a Reserve Price Auction, a notice will be displayed on the listing page next to the
item’s current price. When a bidder’s maximum bid is equal to or greater than the reserve
price, the item’s current price is raised to the reserve price. At this time, the item
information will indicate that the reserve price has been met. The bidder is also notified
that his or her bid met the reserve. At the end of the auction, if there are not new bids
offered within ten minutes of the closing time, then the auction is ended. The highest
bidder wins the auction at the price he/she offered. If there are new bids been offer at the
last ten minutes, then the auction will be extended for another ten minutes.
Dutch Auction Format in Online Auction
This auction format is designed for sellers with many identical items to sell.
Sellers start by listing a minimum price, or starting bid for one item, and the number of
items for sale. Bidders specify both a bid price and the quantity they want to buy. All
winning bidders pay the same price per item—which is the lowest successful bid. This
might be less than what you bid! If there are more buyers than items, the earliest
successful bids get the goods. Higher bidders are more likely to get the quantities they’ve
One interesting point is that the Dutch auction format in the regular auction is quite
different then that in online auctions. The earlier one is a descending auction where price
decrease over time, until one bidder accepts the bid. While in the later one, the winner can
be more than one; the higher bidders are more likely to get the quantities they demanded.
By the end, all winners pay the same price, which is determined by the lowest successful
Priceline.com is another auction site, but it uses a different auction mechanism from eBay
called reversed auction. A reversed auction is where a buyer solicits offers from sellers by
specifying terms of the trade that include specifications, price, delivery schedule and so
on. Once all the interested sellers are notified and assembled, they may compete by
lowering their offers until the buyer accepts one of them. For example, a customer can
specify the maximum price he is willing to pay for airline tickets from LAX of Los
Angeles to JFK of New York city at a specified date. The Priceline acts as a reversed
auction market as it searches for participating airlines’ database. Once an available seat
that match buyer’s requirements are found, the buyer is notified and the buyer is obligated
to purchase the ticket.
Priceline attracts large number of air travelers with its lower prices. Does it push the
overall air travel prices down? The answer is: “Not significantly.” Priceline sells some
seats at lower-than-normal prices, but its inventory comes largely from seats that airline
have determined will go empty otherwise. The result is that Pinceline creates a new
discount market for consumers with flexible travel plan, but doesn’t significantly affect
the supply and demand, or push down prices for business and vacation travelers, who pay
most airline tickets.
Mass-customization is one of the business models that manufactures may adapt to fully
implement price differentiation. By definition, mass-customization means to tailor goods
to individual specifications at a price, on a large scale and within a preset time frame.
With e-commerce, manufactures can provide innumerable selections to customers for
varieties of products. Through the following example we can demonstrate how mass-
customization works in practice.
Raleigh Industries (http://www.raleighbikes.com/live/main/index.html) has set up an e-
commerce site where customers can design their own mountain bike from a “menu”. The
choice started with the Core, which defined the frame material and size along with the
frameset (a cyclist’s term for the package of components such as the cranks and brakes).
This gives a base price upon which some of the further selections can be added on. The
further choices include the color or finish, the type of the front forks, wheel specifications,
gear changers, pedals etc., and giving over 15,000 possible combinations.
Once an order is generated, technicians would follow a unique process according to the
tube material and customer’s specifications to build the frameset. Then the bike-in-
production is going through a cellular style assembling procedure, where one man
assembles one bike. This process ensures the customer gets the best quality of
craftsmanship. At the end, customer is given a signed card with a photograph of the
craftsman who built the bike. The customized bikes are delivered to the door within 1-2
Comparing to traditional market, e-commerce made products even more close to
customer’s preference, therefore it enabled differential pricing techniques to be
implemented at a much finer degree. As we have discussed earlier, that price
differentiation can encourage self-selection among consumers. Online grocery stores, like
grocer.com and webvan.com, are taking full advantage of the Internet; by provide top
quality food at a premium price. Studies have shown that people who shops online usually
have higher than average income, who have somewhat particular requirements on quality
of the goods, they are more health conscious about food and usually don’t have time to
browse the brick-mortar stores for purchases. So the online grocery stores stock their
virtual shelves with only top quality produces, exotic food items from foreign countries.
They also list nutrition fact for all food items and they deliver purchased groceries to the
customer’s doorstep within two hours. This type of consumer niche market is served and
online grocers retain higher profit than the regular supermarkets.
Free for All
An interesting phenomenon on the Internet is that many individuals and organizations
offer digital products and services for free. Free doesn’t mean there is no value associate
with them. These free products or services have great value for someone in need. For
example, many medical facilities maintain web sites that offer medical advice and
information for innumerable illness; publisher offer their collections of scholar journals
articles to readers; educational organizations offers educational interactive games, fun
facts about science and nature that can satisfy children’s curiosity. There are also
thousands of chat rooms and online communities on almost any topic you can think of
that exist on the web. Many people are willing to contribute their time and effort to these
online communities without monetary reward. This phenomenon is certainly welcomed
by the million of online users; however it is a puzzle for the economists who used to
associate products and services with costs and prices in dollars and cents.
Who should pay whom?
Whether these individuals or organization offer services free of charge is an act of
altruism or some other philosophical reason that is beyond the scope of this paper.
However, people who directly involved in these services noticed that there is some
economic reasons that they cannot put a prices tag on their services. One of them is the
distinction between a consumer (who supposes to pay for the services) and a producer
(who supposes to be paid) is blurred. At the end, no body on either side knows who
should pay how much to whom for what.
For example, Rishab Aiyer Ghosh, an economist and a writer, told his own experience in
offering his services online:
While writing my weekly newspaper column on the information society, I was distributing
an email version free of charge on the Internet. A subscription to the email column was
available to anyone who asked and a number of rather well known people began to
receive the column each week. My readers often responded with useful comments; I often
wondered whether people would pay for readership like this. Many readers add to your
reputation, they make good contacts, helping you out in various ways. Simply by reading
what you write, they add value to it – an endorsement, of sorts. So who should pay whom
– the reader for the work written, or the writer for the work read?
Meaning of value and price
Linux, large operating system software, is up to six CD-ROMs when distributed off-line,
is undeniably an economic good (http://www.redhat.com) However, Linux’s developer
Linus Torvalds released the source code free of charge both online and in physical market
(in CDs). Linus Torvalds did not release Linux source code free of charge to the world as
a lark, or because he was naïve, but because it was a “natural decision within the
community [he] felt [he] wanted to be a part of”. (http://www.linux.org). Torvalds is not
the only one who did this; there are others like him in the software developer community.
Most of the technology of the Internet, including tools such as Linux, HTML (the
language of the web) and the web server Apache (with 45% of the total market) are free
Thanks to the large community of other developers and users, who share problem and
solutions, and provide constant, sometimes, daily improvements to the system. Linux
system was improved by millions of user-developers. Because the system is free, there are
thousands of users who depend on it to run their applications. Many of the users not only
report problems, but also play a crucial rule in further development of the system. So
many of them can provide assistance separately that might not be available if they were
all working together in one software company where they would only be developers of
the software no the consumers. This shifting base of tens of thousands of developers-users
worldwide are working on Linux means that the users would have a tough time figuring
out whom to pay, if it wanted to. Therefore, it is just as well that the support from these
developers is free.
One of the most basic concepts of economic is the relationship between supply and
demand. Price is the key in balance this relation so scarce resources are used inn an
efficient way. From the examples above, it is clear that some of the concept need to be
redefined on the Internet. When the cost of duplicating a product is almost zero, what are
scarce resources? When the distribution between supplier and consumers are not clear,
who should pay whom? When Valuable products are distributed with out charge, what are
the means of value and price?
This research was set out to explore the open question that was identified by a group of
researcher (Whinston, Choi & Stahl 1990): how to price digital products and services in e-
commerce. After the research on this subject, we conclude that there “no one size fit all”
answer to this question. To study this subject further, it seems necessary to categorize
online activities at lease into two broad areas. One is the area of e-commerce, where
suppliers provides and services to consumers with corresponding prices. Some of the
existing economic theories and pricing mechanisms can be modified to fit the requirement
if online business. The other one is the area of free exchange of ideas and services, where
no pricing mechanisms could be applied. May be a new economic model should be
constructed to explain the users’ motivation of offering free services.
As long as these two areas remain separated, the pricing seems to be easier. When some
products that use to be sold in the regular market with a price tag, are now being
distributed free over the Internet, then, pricing becomes a challenging issue. Not only
music industry is scramble for a pricing mechanism that would make free file sharing
seems unnecessary, other content-based industries are in the similar situation. We have
proposed a “singing lottery ticket” pricing scheme that might give the users the incentive
to pay a small subscription fee to download the music. Through this price scheme, we
hope to make the free distributing of copyrighted material on online obsolete.
There still are works to be done in the field of pricing digital protects and services. One of
them is how one can implement “singing lottery ticket” idea on the Internet without the
social and psychological drawback of gambling. E-Commerce is changing rapidly; new
communication technologies could affect the pricing strategies. Another approach would
be to initiate a joint effort from other related disciplines to design the pricing mechanism.
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